Banking and private equity
Accounting walk-throughs: the three statements
How to answer "walk me through" questions without losing your place: income statement first, then cash flow, then the balance sheet, and always check that it balances.
How the statements link
The income statement shows profit over a period. The cash flow statement turns that profit into cash. The balance sheet is a snapshot at the end of the period. Three links do most of the work in an interview answer.
- Net income is the first line of the cash flow statement.
- Net income, less any dividends, adds to retained earnings on the balance sheet.
- Cash at the bottom of the cash flow statement is the cash on the balance sheet.
The method
- 1
Income statement
Say which lines change and work down to net income. Apply tax at the rate you're given; if none is given, say you'll assume 25%.
- 2
Cash flow statement
Start with the change in net income. Add back non-cash charges (depreciation, amortization, write-downs, stock-based compensation), then adjust for working capital, investing and financing.
- 3
Balance sheet
Cash moves by the bottom line of the cash flow statement. Change the other assets and liabilities affected, and retained earnings by the change in net income.
- 4
Check
Assets must still equal liabilities plus equity. Say it out loud: "both sides fall by $7.50, so it balances."
Worked examples
Worked example · The classic
Checked by codeDepreciation goes up by $10. Walk me through the three statements. The tax rate is 25%.
Show the working
- 1.Income statement: operating income falls by $10. Tax falls by 25% × $10 = $2.50, so net income falls by $7.50.
- 2.Cash flow statement: net income −$7.50, add back depreciation +$10 because it isn't a cash cost. Cash rises by $2.50: the tax saving.
- 3.Balance sheet: cash +$2.50 and PP&E −$10, so assets fall by $7.50. Retained earnings fall by $7.50, so equity falls by $7.50.
AnswerNet income −$7.50, cash +$2.50; assets and equity both fall by $7.50, so it balances.
Worked example · Working capital
Checked by codeCustomers start paying more slowly: accounts receivable rise by $20 while sales stay the same. What happens?
Show the working
- 1.Income statement: nothing. Revenue is recorded when it's earned, not when it's paid.
- 2.Cash flow statement: the increase in receivables is a use of cash, −$20 in operating cash flow.
- 3.Balance sheet: receivables +$20 and cash −$20. Total assets don't change, and nothing else moves.
AnswerCash falls by $20; total assets, liabilities and equity are unchanged.
Worked example · Debt-funded equipment
Checked by codeA company borrows $100 at 5% to buy equipment, depreciated over 10 years. Walk me through the end of year one. Tax is 25%.
Show the working
- 1.Income statement: depreciation $10 and interest $5, so pre-tax income falls by $15. Tax falls by $3.75. Net income falls by $11.25.
- 2.Cash flow statement: net income −$11.25, add back depreciation +$10, so operating cash flow is −$1.25. Investing −$100 (the purchase) and financing +$100 (the loan) cancel. Cash falls by $1.25.
- 3.Balance sheet: cash −$1.25 and PP&E +$90 (100 less 10 of depreciation), so assets rise by $88.75. Debt +$100 and retained earnings −$11.25, so liabilities and equity rise by $88.75.
AnswerNet income −$11.25, cash −$1.25; both sides of the balance sheet rise by $88.75.
TipSay each statement's change in one sentence, then move on. Interviewers mark the structure as much as the numbers.
Variations to be ready for
- An inventory write-down of $10: the same as depreciation on the income statement and cash flow; on the balance sheet, inventory falls instead of PP&E.
- $10 of stock-based compensation: net income falls by $7.50, the $10 is added back as non-cash, cash rises by $2.50, and shareholders' equity gets the $10 back through paid-in capital (so equity rises by $2.50 in total).
- A $10 dividend: no income statement change; financing cash flow −$10; cash and retained earnings both fall by $10.
- Accounts payable up by $10: a source of cash. Cash +$10 and payables +$10.
Common mistakes
Common mistakes
- Forgetting tax on any change that goes through the income statement.
- Adding back items that are cash costs. Only non-cash charges are added back.
- Getting working capital signs backwards: an increase in an asset (receivables, inventory) uses cash; an increase in a liability (payables, deferred revenue) provides cash.
- Stopping before the check. Always finish by saying the balance sheet balances, and by how much each side moved.
Practice this
Put the method to work on fresh questions, marked instantly.
Banking and private equity